Before the global financial crisis, borrowing to invest was all the rage but now we?ve become more cautious, writes Leng Yeow.
As the end of the financial year looms ever closer (only 32 sleeps), the thoughts of investors naturally turn towards tax-effective ways to make money. Don?t be surprised, then, if the media, your accountants and financial advisers start talking about gearing strategies.
That?s because interest paid on investment loans ? say, to buy a parcel of shares ? is deductible and you can pre-pay that interest to claim a deduction come tax time.
But tax benefits alone are not a good enough reason to gear into an investment, warns Sydney-based financial planner Warren Skinner of Fintuition.
?The most important consideration is: does the underlying investment make sense?? Skinner says.
This means you need to first consider whether you?re putting your hard-earned money into a quality investment and that you?re comfortable with the risk involved.
Only once an investment passes that test can you start thinking whether it?s better to invest with cash or borrowed money, or a mix of the two. Put simply, the more money you have to invest, the more money you can make. However, the more you borrow, the greater the risk, as gearing can also amplify your losses. If the market suffers a major fall, not only could you lose your entire investment, you could end up owing the lender.
Ups and downs
Skinner says investors typically focus too heavily on the upside without a balanced view, which includes the potential downside.
He adds that in the past many financial advisers have also promoted the tax benefits of gearing without giving due consideration to the quality of the underlying investments.
Perth-based financial adviser Patrick Canion says investors can borrow to invest all year round because gearing is not seasonal and a tax break should not influence your decision of whether or not to invest.
?It?s not about spending 55 cents to save 45 cents. If it?s a quality investment, which matches your risk tolerance and happens to attract a tax deduction, then that?s a bonus; but a tax deduction is not a fundamental reason to invest,? Canion says.
?If you?re thinking about getting an investment loan but you?re not quite ready, there?s no rush.? Canion adds that five or six years ago, when personal income tax rates were much higher, there was more of an emphasis on gearing towards the end of the financial year.
It also appears investors have matured since the global financial crisis, which gave all of us a harsh lesson in the reality of what happens when you?re carrying too much debt and things turn sour. That?s led to less demand for products such as margin loans and structured products.
The popularity of gearing as a wealth creation strategy soared before the peak of the sharemarket mid-2007. As the market climbed higher and higher, more Australians took out investment loans.
But that trend quickly reversed during the GFC as investors watched the value of their portfolios plummet. As share prices fell, investors came under pressure to put more money into their accounts. In the face of these margin calls, some people were forced to sell their assets at low prices to repay the loans.
Confidence is now slowly returning but investors are being more conservative. While the number of margin loan accounts crept up to 229,054 at the end of March this year (compared with 247,522 at the end of 2007), the total debt outstanding was $19.2 billion compared with the peak of $41.6 billion in December 2007, according to the Reserve Bank of Australia.
The average loan-to-value ratio has fallen to 33 per cent, compared with 45 per cent in 2007.
According to the head of sales and distribution at Westpac Institutional Bank, Craig Keary, you don?t need to borrow large amounts to enjoy the benefits of gearing.
?Even with a conservative borrowing level of 30 per cent, you can still increase your returns,? he says. ?By taking a sensible approach, you can start to accelerate your wealth with less risk of receiving a margin call.?
Fintuition?s Skinner says only a handful of his clients have investment loans. But borrowing to invest can be appropriate if there is a mismatch between what you want to achieve in the future financially and your current income and resources. ?Then we have a conversation with them about gearing because it is one way they could reach their goals,? Skinner says.
The right approach
There are several different strategies. Investors can get a margin loan, borrow against the equity in their home, invest in an internally geared managed fund or get a protected-equity loan.
Geared funds are managed funds that borrow and invest additional funds on behalf of investors. By raising money within the fund structure, the fund creates leverage without the need for investors to borrow in their own name or meet margin calls. These products can be quite cost effective. Geared funds are typically the cheapest to finance, followed by home-equity loans, then margin loans and lastly structured products and protected-equity loans.
But while geared funds may be the cheapest option, they lack transparency and don?t give investors control over stock selection, asset allocation, the level of gearing or tax treatment.
You may also be exposed to unintended tax consequences, particularly if invested in a fund that actively trades stocks.
According to the general manager of Core Equity Services at Colonial Geared Investments, Pete Steel, the popularity of home-equity loans is rising.
?The general trend is to invest cash first, then take out a home-equity loan ? and once confidence fully returns, we?ll see more investors gear using a margin loan,? he says.
Historically Australians have kept their residential homes separate from other investments, despite being able to access capital at a lower interest rate than a margin loan.
Reserve Bank figures show the average home loan rate is 7.8 per cent compared with a margin loan rate of 9.65 per cent.
Steel says investors are starting to realise that the equity in their homes is not being utilised and some are reluctant to put themselves in a position where they?re open to a margin call so ?a home-equity loan, while it allows investors to invest in the same assets, is slightly more innocuous?.
Rates aside, a margin loan has its own advantages. For starters, the barriers to entry are lower because you don?t need to have a home and for that home to be independently valued in order to determine the level of capital accessible.
Anyone can apply for a margin loan. Lenders know the value of the underlying asset based on its market price.
Margin lenders are also responsible for monitoring and reporting on portfolios.
Choosing the right investment and determining the appropriate gearing strategy and level of gearing depends on what you are trying to achieve and your risk appetite.
Borrowing more than half the value of a diversified portfolio of shares or a managed fund is considered high risk. And the less diversified your portfolio or investment, the greater the risk. For example, borrowing to invest in one company or concentrating your portfolio in one sector is not a good idea.
The prudent alternative
For risk-averse investors, there are other ways to build wealth without leverage, such as investing in high-yielding growth assets.
A savings plan is one alternative to consider. It may be better to save and invest gradually over time, rather than using your cash flow to repay interest on a loan, Canion says.
For example, if the interest payments on an $80,000 loan are $500 a month, you could choose instead to invest $500 a month into an Australian equities fund and watch it grow over time.
?If you weigh the two options up, over the course of 12 months, the net results are not dissimilar,? Canion says.
?Of course, the interest on the loan is tax deductible but if your personal income is around $80,000, your tax saving will be approximately 35 cents in the dollar and you?ve taken on a whole lot of risk to achieve that as a $100,000 portfolio could quickly fall to $80,000 if there?s a major market downturn.?
About 15 per cent of Canion?s clients borrow to invest, of which 10 per cent have a home-equity loan and 5 per cent have a margin loan. Few invest in internally geared share funds.
Keary says investors are hungry for information and many advisers recognise that their clients need some form of leverage.
?Now it?s a case of determining the best strategy because as a result of the GFC there?s a wider range of options available,? he says. ?Investors are considering home-equity loans, protected-equity loans and while margin lending continues to be a popular option, they?re choosing lower loan-to-value ratios.
?At some point investors need to start building up their portfolios again, especially after a long period in cash.?
Line-of-credit loan risky yet attractive
At the start of the year, financial adviser Patrick Canion took out a $100,000 home-equity loan to invest in a State Street?s SPDR S&P/ASX 200 exchange-traded fund (stock code STW). Every month, Patrick repays the interest on the loan in full, about $500.
?I thought the Australian sharemarket was reasonable value but because I?m not a stock picker, I took out a line of credit secured by my home and invested in an ETF,? he says.
?Hopefully at some point in the future, I?ll start to see some capital growth in my investment, although it has been going sideways for the last six months.?
According to Patrick, gearing made sense because of his high income tax rate and his cash flow.
Not only can he claim a tax deduction on his interest bill but if he holds the investment for 12 months or more, only half of any capital gains will be taxed.
?You can?t pre-pay interest on a home-equity loan but it?ll get the deduction next year,? he says. ?I?m making extra repayments on my mortgage, I make the maximum super contribution and I can afford to take a little extra risk, so gearing was the next step.
?Rather than pay $500 in interest a month, I could just save the money and invest, which would be a lower-risk strategy.
?But because I see the Australian market as good value and I can afford the risk, I decided to gear into the investment.?
Tags: home equity loans
Source: http://bestloanscheap.com/home-equity-loans-gearing-up-to-build-on-wealth/
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